Peak earnings? Why an equity rotation may be nearing.

Market Recap

• Markets had a lot to digest this week, and they had some trouble doing so. The S&P 500 slipped 0.8%, and was down almost 5% from last week’s record high before a rebound on Friday.

• Investors have some more clarity on the political battle ahead, with President Biden officially announcing that he won’t run again, presumably setting the stage for a Harris vs. Trump election.

• But November is a long way away in market terms, and the outcome remains uncertain despite last week’s ‘Trump trade’.

Earnings

Earnings season is underway again, and so far, it’s been a bit of a disappointment for markets. We wouldn’t classify the earnings as bad per se, but markets’ recent strength means that the bar has been set so high that it’s easy for companies to fall short of expectations; Alphabet (Google) and UPS’ earnings were examples of this. There were some beats, however, like Coca-Cola. We’d categorize Coke as more of a Consumer Staples brand than anything else, so this seems to reflect the adjustment in consumer spending—a shift from Discretionary to Staples—that I’ve discussed previously in this space. Our suspicion is that we’re close to peak earnings, meaning that valuations are going to be tougher to increase from last year. Last Wednesday saw the S&P decline more than 2% in a single day for the first time in nearly a year, and volatility ticked up as well. These are warning signs that we need to monitory closely as more earnings announcements roll out. If investors believe that earnings are not likely to get better from here, then they may feel it’s time to rotate to other areas, which could impact some of the market heavyweights.

Bottom Line: So far, earnings season has been something of a disappointment, and the time for a rotation could be nearing.

Presidential Election

A lot has changed in a week. Seven days ago, President Joe Biden had just announced his decision not to run for re-election, and while Vice President Kamala Harris seemed the favourite for the Democrats’ nomination, it wasn’t yet a certainty. Since then, Harris has effectively wrapped up the nomination, having secured the endorsements of a majority of convention delegates and party heavyweights like Nancy Pelosi and former President Barack Obama. This change at the top of the ticket appears to be a big plus for the Democrats. Prior to Biden’s decision, the Republicans seemed to own virtually every path to victory in November, especially given many Democratic voters’ lack of enthusiasm for Biden as a nominee. Now, Trump is facing a younger and arguably more dynamic opponent. A big sign of Democrats’ renewed enthusiasm has been the influx of funding—the floodgates opened once Kamala became the presumptive challenger. There is also the potential that Harris could energize women voters, who have been a weakness for Trump previously; exit polls showed that Trump lost the women’s vote by 15 percentage points in 2020 and 13 points in 2016. Kamala’s momentum aside, the odds are still favouring Trump. But it’s worth remembering that the news cycle is short and many of the events that had given Trump a clearer advantage in recent weeks—including Biden’s debate performance and the assassination attempt—may be largely forgotten by November. We don’t think the chances of a Kamala victory are properly priced into markets, and it would be wise for managers to think about how to protect or adjust portfolios in case that scenario plays out. In our view, a Harris administration wouldn’t necessarily warrant an equity sell-off, but it could justify some sector rotation.

Bottom Line: While Trump is still the favourite, Harris’ momentum has improved the Democrats’ chances of winning, and markets should prepare for that possibility.

Interest Rates

Last week, as expected, the Bank of Canada (BoC) lowered interest rates by 25 basis points, the second such cut so far this cycle. There was also a comment by the BoC that suggested more cuts could be on the way if inflation numbers remain on their current trajectory, which was a particularly good sign. The Canadian dollar did weaken a bit on this news, but that could also be attributed to strength in the U.S. dollar owing to turbulent markets. Overall, we believe this is the right move for Canada—the cut will give some confidence to consumers, provide relief to the mortgage market, and potentially stem the gradual weakening of the economy. The trend toward lower rates in Canada is now definitive, and that’s likely to be good for Canadian bonds. Our expectation is for at least one and potentially two more rate cuts from the BoC this year. Though we expect the U.S. Federal Reserve (Fed) to deliver its first rate cut in September, the BoC currently has a 50-basic-point head start. We think this could lead to some outperformance by Canadian bonds versus U.S. bonds. At our upcoming asset allocation meeting, we will strongly consider changes within our fixed income sleeves, including a move away from cash and the potential addition of duration.

Bottom Line: The BoC’s rate cuts are the right move and could be good news for Canadian bonds.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Politics and profits: Finding wins in an election year.